Case For The Mauritian Stock Exchange

Published Date: 02 Nov 2017

Chapter 1

Introduction

Volatility is a vital occurrence in markets in general and especially in security markets. Modeling stock market volatility has been the focus of empirical and theoretical analysis by both academicians and practitioners. As a notion, volatility is simple and intuitive. It measures the variability or dispersion about a central tendency. In other words, it measures how for the current price of an asset diverges from its average past values. The study of volatility becomes more significant due to the increasing associations of national currency, goods and securities markets with rest of the world and common players have provided volatility with a new feature- that of its rapid transmissibility across markets.

Financial asset prices have posted very large swings in recent years. This pattern of remarkable variations has stimulated interest in market volatility amongst academics, market practitioners and regulatory and supervisory authorities. Study of these happenings is warranted since market shocks can have an impact on financial stability and have repercussions in the real economy. Yet, price instabilities are innate in the very existence of markets, each participant incurring the risk of making a loss. The question that has been the at the center of economic and financial literature for about 100 years now is whether it is possible to estimate this risk in theoretical and empirical terms. Much of the research in this field is likely to assimilate the concept of risk to the volatility of returns.

Even though investors often use the volatility of equity returns as a tool for determining risk, estimating volatility still raises problems and care should be applied when understanding it. However, an investigation of different obtainable volatility indicators suggests that stock market volatility has shown an upward trend. This rise is most visible for technology, media and telecommunications stocks. Yet, when seen in the very long-term perception, the current level of stock market volatility does not appear abnormal or even unusually high.

Recent volatility trends stem mainly from the lasting and considerable fall in stock price from the highs reached in 2000, a large number of shocks affecting the financial economy, heightened uncertainty about geopolitical and macroeconomic developments and investors’ growing doubts about the quality of financial assets against the conditions of weaker corporate capital structures.

1.1 Background of Study

In finance, volatility is a measure of variations of asset prices. According to Schwert (1990a), finance researchers use proportion changes in prices or rate of returns to evaluate the volatility of a financial market. Furthermore, in reaction to new information, price of stocks adjust rapidly; thereby volatility of stock markets is a sign of high liquidity of the market (Schwert, 1990a). On the other hand, Bauwens et al. (2003, 2006) stated that financial variations occur together over time across assets and markets which mean that the volatility of one asset or market can lead the volatility of other assets or markets.

The recent global economic and financial crisis has enthused research on the relationship between financial markets and the macro-economy. There is by now significant evidence provided by researchers that positive uncertainty shocks may hinder economic activity. Nevertheless, the literature does not explain whether this relationship is stable over time.

Using data of SEMTRI since 1990 until 2011, we reveal that the macroeconomic trends to stock market volatility changes rather distinctly over our sample period both in qualitative and quantitative terms. It is imperative to explore such changes in the macroeconomic response pattern, because this might provide policymakers with further insights on the (relative importance of the) channels through which uncertainty shocks affect the macro-economy and on the role that policy plays in the transmission. Moreover, to the extent that uncertainty is attributable to policymaking, it provides them with information on changes in the costs of policy uncertainty.

There are several potential channels through which an unanticipated raise in uncertainty in the economy may affect macroeconomic variables. It may lead to a rise in precautionary savings (e.g. Carroll and Samwick, 1998), thereby depressing consumption spending. It may increase the required return for bearing systematic risk in financial markets, thereby pushing up the cost of capital and, hence, depressing investment. Higher uncertainty also moves up the value of the option-to-wait in making irreversible investment decisions, thereby slowing down investment expenditures (e.g., Bernanke, 1983, Dixit and Pindyck, 1994, and Bloom et al., 2007). The same is true for durable consumption goods. Finally, it is sometimes argued that higher (stock) market volatility reveals improved uncertainty about future cash flows and discount rates that result from expected resource-consuming structural changes that depress GDP growth (see Campbell et al., 2001). Hence, in a regression of GDP growth on lagged stock market volatility, the latter variable is expected to enter with a negative coefficient.

1.2 Importance of Study

There are several reasons to take up this study now. First, opinions vary about the spread of Mauritian stock prices.

Second, evaluation of time series volatility of Mauritian equity market with other emerging and developed markets, distributional features of the variance process and evidence if any, of asymmetries in volatility under diverse market situations may shed interesting light on the growing characteristics of Mauritian equity market. The increased contribution of institutional investors, global economic crisis and its outcome on world stock markets in general and Mauritius in particular calls for a comparative study on volatility in emerging and developed stock markets.

Third, at the level of investor, frequent and wide stock market fluctuations may result in uncertainty about the price of an asset and influence the confidence of the investor. Risk averse investors may retreat from market with regular and sharp price movements. An understanding of volatility over a period of time is important from the viewpoint of individual investors.

Finally, organizations assigned with the job of controlling the market also call for a clear idea regarding the trend of volatility for framing policies to guard the interest of investors. So, an awareness of the market fluctuations is therefore essential view of the regulatory policy as well.

1.3 Brief Objectives

The main objective of this study is to consider stock market volatility and its related stylized facts in the Mauritian stock markets. This will enable us to understand the stock market and its importance as well as to find out the reasons behind the downfall. The study is also meant to analyse volatility measures, as well as seeking to establish relationships between stock volatility and market shocks; both positive and negative shocks.

1.4 Structure of Thesis

The dissertation is organized as follows.

Chapter 1 is an Introduction of the dissertation. It briefly mentions the dissertation objectives, importance and methodology conducted in the dissertation.

Chapter 2 provides an overview of the Mauritian Stock Market including the background, the organization and operation and the main features of Vietnam stock market index.

Chapter 3 focuses on the theoretical and empirical review of stock market volatility. The concept of stock volatility is further explained, with the focus on studying about what major experts have written on the particular topic.

Chapter 4 describes the data characteristics and research methodology employed in this dissertation. The chapter provides a preliminary analysis of the data set and introduces alternative models adopted for modelling and forecasting volatility.

Chapter 5 illustrates the results and analysis obtained from the empirical tests with some interpretations of GARCH specifications in modeling volatility of Mauritian stock market and comments on the superiority of a certain model over the others.

Chapter 6 is Conclusion part which summary the outcome and provides some limitations and recommendations for further studies.

Chapter 2

Overview of Mauritian Stock Market

The Stock Exchange of Mauritius Ltd (SEM) was incorporated in Mauritius on March 30, 1989 under the Stock Exchange Act 1988, as a private limited company responsible for the operation and promotion of an efficient and regulated securities market in Mauritius. Since October 6th, 2008, the SEM has become a public company, and over the years the Exchange has witnessed a significant overhaul of its operational, regulatory and technical framework to reflect the ever-changing standards of the stock market environment worldwide. SEM is today one of the leading Exchanges in Africa and a member of the World Federation of Exchanges (WFE).

The SEM is presently going through a strategic reorientation of its activities and gradually moving away from an equity-based domestic Exchange to a multi-product internationally oriented Exchange.

SEM has made some important strides in its development process since 1989 and looks well poised to continue reforms in order to contribute towards the enhancement of the operational and regulatory efficiency of the local market. SEM has the vision to steadily move from a domestic-equity-focused Exchange to a multi-product-internationally-focused Exchange. In the years to come, the split of listings on SEM is expected to overwhelmingly consist of international funds, international issuers, specialized debt instruments, Africa-focused Exchange-traded funds and other structured products. The value of products traded and settled in USD, Euro, etc. is expected to increase over time, confirming the internationalised status of the SEM over time. As SEM also aspires to emerge as a capital raising platform for Africa-focused investments routed through the Global Business Sector, the SEM platform will growingly be used to channel investment flows from SA/Europe/Asia into Africa and from USA/Europe into Asia. The number of issuers, players and investors in our market will increase over time, increasing the breadth and depth of our market in Mauritius, and thereby also bringing a meaningful contribution to the integration of the Mauritius financial services sector within the international financial system. SEM also aims at consolidating its position with a view to further contributing more broadly to the development of the Mauritian economy and of capital market activities on the national and regional fronts.

2.1 Principal Activities of the SEM

The principal activities of the SEM, as defined by its Constitution, include the following:

Operating and maintaining a securities exchange in accordance with law.

Providing facilities for the buying and selling and otherwise dealing in securities on a securities exchange.

Providing and maintaining, to the satisfaction of the Financial Services Commission, adequate and properly equipped premises for the conduct of its business.

Having operating rules for the markets it operates pursuant to law.

2.2 Operation of the SEM

The SEM operates two markets: the Official Market, the Development & Enterprise Market (DEM). The Official Market started its operations in 1989 with five listed companies and a market capitalisation of nearly USD 92 million. Currently, there are 38 companies listed on the Official Market representing a market capitalisation of nearly US$ 5,788.01 million as at 30 September 2011. The DEM has been launched on 4 August 2006 and there are presently 49 companies listed on this market with a market capitalisation of nearly US$ 1,916.85 million as at 30 September 2011.

2.3 SEMTRI and the performance of the Mauritian Stock Exchange

The SEMTRI is a Total Return Index launched in October 2002. Its main purpose is to provide domestic and foreign market participants with an important tool to measure the performance of the local market.

The SEMTRI constitutes a very good indicator of the performance of the overall stock market. It provides a good benchmark of the evolution of the stock market. It captures the two forms of return that an investor may expect to generate from his investment , namely, capital appreciation and dividend payments. The SEMTRI also enable the SEM to regularly publish the list of top performing companies in terms of capital growth and dividend payments.

Figure 1: Performance of SEMTRI from 1 Jan 1990 to 31 Dec 2011

The Figure 1 describes the movement of SEMTRI over the past twenty two years which is the estimation sample period. In general, the SEMTRI series has upward trend from 1990 to the end of 2008. The most rapidly development was seen in beginning 2008.

Overall, 2008 was a year that saw substantial market volatility. The SEMTRI which had reached an all-time high during February shed 34% during 2008. Throughout the year, there have been many factors which concerned local investors: high inflation, strong rupee, rising commodity prices, slowdown in tourism arrivals as well as the risk of an economic slowdown.

SEMTRI fell to its lowest level at end of February 2009 largely as a result of the fall in prices of the local stock counters. It however recovered and rose again in end of 2009. The upward trend continued until it reached its peak in June 2011.

A dip was witnessed in February 2011 as a result of uncertainties prevailing in North Africa, and in the second half of the year, as a result of volatility. The market rose temporarily during the second quarter of the year and again in December 2011.

Over the year ended 30 June 2011, SEMTRI rose by 30.4%. Good augur from international markets as well as positive results being posted by the local companies contributed to restoring investor confidence and driving the markets upwards with an increase in annual turnover of 12.5% and 18% in market cap. Market Price Earnings ratio furthermore stood at 15.4% at end June 2011.

Figure 2: Number of Stocks Traded from 1990 to 2011

Over the years 1990 to 2006, there was a general upward trend in the number of Stocks traded with some fluctuations. Some rises were experienced mainly in 1994, 1997 and 200, 2003 and 2005. Each rise was followed by a substantial fall in stocks traded in the following year, with the highest decrease in 2002.

The sharpest rise was experienced in 2007. In fact, The Stock Exchange of Mauritius (SEM) had a record year in 2007.Market capitalisation in local currency increased by 70 per cent over 2006, and was worth more than 100 per cent of GDP in early 2008. The SEM also provided a very good return to investors.

Volume of trade fell again in 2009, but recovered to reach its peak in 2011.

Chapter 3

Literature Review

Volatility is one of the main features of the financial market, playing a significant role in managing portfolio, pricing of options and market conventions (Poon and Granger, 2003). Stock returns volatility varies considerably across global and have received a great consideration from researchers over past years since it can be utilized as a means to calculate risk in financial markets. Instability of stock returns has been a topic of interest in financial literature since long. A broad range of research has been carried out on stock returns volatility in both advanced and developing markets since 1970s. Financial economists are also curious about the sources as well as the inconsistencies relating to market volatility.

3.1 Theoretical Review

3.1.1 Stock Markets and Stock Exchanges

A stock exchange or bourse is a corporation or mutual organization which provides the facilities for stock brokers to trade company stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities, as well as other financial instruments and capital events including the payment of income and dividends.

In other words, Stock Exchanges are an organised marketplace, either corporation or mutual organisation, where members of the organisation gather to trade company stocks and other securities. The members may act either as agents for their customers, or as principals for their own accounts.

Stock exchanges also facilitates for the issue and redemption of securities and other financial instruments including the payment of income and dividends. The record keeping is central but trade is linked to such physical place because modern markets are computerised. The trade on an exchange is only by members and stock broker do have a seat on the exchange.

The securities traded on a stock exchange include shares issued by companies, unit trusts and other pooled investment products as well as bonds. To be able to trade a security on a certain stock exchange, it has to be listed there.

Usually there is a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only; a stock broker is said to have a seat on the exchange.

The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public. The Stock Exchange also play an important role in the economy by mobilising Savings for Investment, Redistribution of Wealth, Improving Corporate Governance, Creates Investment Opportunities for Small Investors, Raises Capital for Development Projects and finally it acts as a barometer of the Economy.

3.1.2 Factors Affecting the Stock Market

Many kinds of factors affect the stock market. Social unrest can cause the market to drop, while a company discovering a new source of renewable energy can cause stock market prices to soar. Several economic factors affect the stock market that every investor should be aware of before getting involved in market investing.

Inflation And Deflation: Inflation, which is the rate at which the price of goods and services increases, can have an adverse affect on the stock market. High inflation causes investors to think that companies may hold back on spending; this causes an across the board decrease in revenue and the higher cost of goods coupled with the drop in revenue causes the stock market to drop. Deflation is when the cost of goods drops. While deflation sounds like it should be welcomed by investors, it actually causes a drop in the stock market because investors perceive deflation as the result of a weak economy.

Interest Rates: Interest can have an impact on the stock market. Higher interest rates mean that money becomes more expensive to borrow. To compensate for the higher interest costs, companies may have to cut back spending or lay off workers. Higher interest rates also mean that a company’s money cannot borrow as much as it used to, and this has an adverse affect on company earnings. All of this adds up to a drop in the stock market.

Foreign Markets: Economic trends in foreign markets can have an effect on the stock market. When the economies in foreign countries are down, local companies cannot sell as many goods overseas as they used to. This causes a drop in revenue, and that can show up as a drop in the stock market. Foreign stock exchanges also have an effect on the local stock market. If foreign exchanges start to fail or experience sharp drops, then that kind of activity can cause local investors to anticipate a ripple effect, resulting in a drop in the stock exchange.

3.1.3 Stock Market Volatility

Volatility, in its simplest form, refers to the variation in the price of a stock. Volatility of a security market is determined by the variation in the price over a period of time, calculated as the standard deviation of the market returns. The greater the variance, the greater is the asset volatility. An awareness of volatility in stock markets is therefore essential for finding out the cost of capital and for assessing investment and leverage decisions as volatility is identical to risk. Considerable shifts in volatility of financial can have major negative effects on risk averse investors.

3.1.4 Sources of Volatility

The issue of stock market volatility has obtained much attention in the finance literature. Securities markets are often characterized by periodic bouts of volatility, whereby prices will increase and decrease sharply and randomly. This volatility is often incited by economic causes, which have an effect on the confidence that investor have on the listed companies, resulting in a movement of their funds into and out of the securities.

Inflation can be seen as a major source of stock volatility. Inflation is said to occur when there is a continuous rise in the general price levels which causes the value of a currency to fall. Whilst mild inflation is regarded as normal, it is feared that if the rate of inflation is rising too fast, this can lead to volatility in the securities market, since inflation has an unpredictable effect on an economy and have an effect on different firms in different ways. As their expenses are rising, companies are likely to charge a higher price for their goods.

Consumer expenditure is the lifeblood of an economy. There is development in the economy as consumer spending rises and firms suffer when there is a fall in consumer spending. That's why, investors focus mainly on consumer expenditure indices. Signs of a variation in consumer expenditure can affect the economy. When the market obtains different indications; for instance, enhanced consumer assurance along with a fall in expenses can cause volatility.

Interest rates are defined as the amount charged, by a lender for the use of money by the borrower. Time and again, this rate may be influenced by the monetary policy adopted by central bank. When there is a low rate of interest, people are likely save less money, since banks are offering low returns on their deposits. When there is an increase in interests, saving increases as well. The consequences of variations in the interest rate can be understood in different ways by different investors, which results in volatility.

The wellbeing of foreign economies, generally revealed in activities on their stock exchanges, can have various different impacts on local markets. In certain cases, investors will fear that crises in foreign countries may affect the local country and thus cause securities prices to drop. In other circumstances, investors will transfer funds from overseas firms into local firms, resulting in an increase in prices. The interaction of these two responses can generate volatility.

The bond and the securities markets are directly related. Many firms listed on the securities market have issued bonds on the bond market or, in the case of investment banks and other firms that manage huge financial portfolios, hold several of the bonds. Instability in the bond market, can have an effect on the price charged by firms to lend money and this can be the source volatility in the securities market.

Dividends are among the most frequent sources of stock market volatility. Basically, dividends are the income paid to investors by firms when the business is flourishing. If a company has a very unproductive year, it may not make any dividend payments. If investors come across information that makes it looks that dividends for a firm (or particularly an industry) will go down, then securities prices will rapidly drop. Unfortunately, volatility most often indicates an abrupt reduction in price rather than an unexpected increase.

Stock market efficiency can also be seen as a reason of some volatility. Although the securities market is mostly electronic, not all information movement is instantaneous. Information requires time to arrive at investors and have an effect on the market itself. There are interruptions and misunderstandings. Consequently, the market loses firmness and responds too easily to information that is not evenly corresponded.

Investor response is a further source of volatility in the securities market. If the market seems as if it is collapsing, then many investors will promptly dispose of their shares or trade to compensate expected losses. This makes the market drop even more rapidly in a snowball reaction. Investor reactions to unexpected movements of the market often worsen the problem.

Business performances and shifts directly have an impact on the securities market. This indicates that aspects in businesses that swiftly vary also be at the origin of sudden market changes, and thus causing increased volatility. A company may all of a sudden amend a marketing promotion, or get itself manipulated by latest business legislation, or may have to to abruptly alter inventory. Any practice that a business may rapidly modify can also cause abrupt changes in the securities market.

3.1.5 Stock Market shocks

The term "shock" refers to an outlier which has been triggered by an event exogenous to the market. Therefore, a stock market shock can be referred to as a disruption of market equilibrium (that is, a market adjustment) which reflects substantial pieces of market news. Market shocks can have an impact on financial stability and have repercussions in the real economy.

News of local or world events can impact stock value. If a company announces the closing of a division or the layoff of workers, that may cause the company’s stock price to drop. On the other side, bad news about a company may cause the stock value of its competition to go up. Market shocks may also result from announcements made by the company, such as merger decisions, dividend payments or publication of financial statements.

3.1.6 Causes of Market Shocks

There are several circumstances whereby pieces of news relating to a particular company can cause a market shock which in turn impact on share prices. Some of them are described below:

Market Scandals: Traders tend to frown upon corruption in the stock market. Mutual fund scandals that have occurred in the past few years and corporate corruption such as Enron are two such examples. If people cannot trust the stock market, why would they invest their hard-earned money in it? In these situations it is harder for the market to go up because there is a lower demand for stocks.

Analyst Recommendations: Many traders rely on experts' opinions about companies and future stock prices. However, they are not always correct. Nobody can predict what will happen in the future. They can, however, make educated guesses based on past performances and future prospects for the companies and industries they follow. Analysts’ recommendations on "buy" or "sell" decisions affect prices of stocks in question as investors normally take heed of such recommendations. The public normally accepts the advice given by the analysts since the analysts are specialists in their respective fields. 

Credit Rating News: Many Credit rating agencies track the performance of companies and rate them on periodical basis. If a major credit rating agency downgrades its rating on a company and the news is released on TV channels or print media, than market reacts to it and share price fall. The reverse happens when credit rating agency upgrade their rating on a company.

3.1.7 Impact of Market shocks on share prices

Market Shock is an important factor that affects the share price. When there is positive news or shock about a particular stock or company, people try to invest all their money in that particular stock or market. This leads to increase in the interest of buying the stock. But there are many circumstances where news could also bring a negative effect where it could ruin the prospect of the particular stock. So it is very important to know the overall news of a stock or company where people can invest their money so that it grows within a very short period of time.

News from the specific company and other domestic and global events also play a large role in the direction of the share price and stock market. Some examples of these are interest rates of major economies, monetary policies and export policies, oil prices, inflation, and terrorist attacks and so on. Every analyst and trader has a different perception of what that stock price should be now and where it might be in the future, and trading decisions are made accordingly. 

3.1.8 Relationship between Market Shocks and Stock Market Volatility

Stock market volatility shocks are associated in a causal way to output and inflation volatility shocks. A non negligible portion of the short run stock volatility process is not explainable on the basis of the persistent volatility factors, and may be seen as a reaction to shocks to market volatility itself.

There are many economic reasons for which larger, in magnitude, return shocks can cause persistent shifts in the level of market volatility, which can change over time. These can be attributed to Financial leverage effects or feedback volatility (risk premium). If the shifts in volatility are not accounted for, they will overstate evidence of very high persistence in volatility. A smaller degree of persistency can dampen the feedback volatility effects faster, and thus positive (good) return shocks will result in significant drops of volatility.

3.1.9 Announcements causing Stock Market Volatility

Stocks price changes due to market forces, i.e. buying and selling of the available stocks in the market. The following are the some announcements that affect or even predict the buying or selling of stock that ultimately affects stock prices of companies.

The earning results and earning guidance: The main objective of a company is to make profit. Therefore, investors and traders always assess a company based on its Earning Per Share Revenue and its future earning potential. In Mauritius, companies generally report the earnings results every quarter-yearly. A company that achieves good earning results (EPS and Revenue) expects a boost in its share price and one that delivers poor earning result shall see a beating in its share price. Sometimes, besides reporting the EPS and Revenue for the past quarter, a company may also issue guidance (expected value) for the EPS and Revenue in coming quarter or coming years. This is also closely monitored by investors and is an important factor that will affect the company stock price.

Take-over or merger: In general, a company being taken-over is anticipated to get a stock price boost and the company taking over another company shall experience a drop in its share price. This is assuming that the company is being taken over at a premium, meaning it is being bought over at a higher price than its last traded stock price. Depends on the agreed term, a company can be bought over by cash or stock (of the acquirer) or a combination of the two. In some minority cases, the stock price of the acquirer may get a boost if it is perceived that the acquisition shall contribute to its earning or revenue in the near future.

New product introduction to markets or introduction of an existing product to new markets: The introduction of new product to market is seen as a revenue enhancer for a company. This also applies to an existing product that breaks into new markets. Sometimes, the prospect of a new product introduction suffices to improve the stock price of a company, this is often observed in surges in stock prices of pharmaceuticals companies after the announcement of successful clinical trials, or FDA approvals for new drugs.

New major contracts or major Government Orders: A company that is able to obtain new major contracts or major government order is expected to see a bull run in its stock price. Those companies that fail in the contract bidding normally experience the fate of sell-off in its stocks.

Share buy-back: The act of share buy-back by a company will reduce the number of share available in the open market. Due to the law of supply and demand, a reduction in share available for trading in this case will cause a drop in supply, this will normally help increase the share price. Also, the continuing buying back of share of a company will also acts as a support for the share price that helps to maintain or increase the share price.

Dividend: After the announcement of a dividend. The stock price may increase by an amount close to the dividend per share value. However, the stock price may drop on the ex-dividend date by the dividend per share amount. This is because anyone buying a stock on or after the ex-dividend date are not entitled to the corresponding dividend payment.

3.1 Empirical Review

Madhavan (1992) explains volatility in the form of price divergence. Low volatility is needed since it reduces the unnecessary risk taken by investors and because to this market traders can easily sell their assets without facing the risk of adverse massive price movements. On the other hand, Jayasuriya (2002) argue that volatility is harmful as it makes investors averse to holding stocks, increase risk premiums and the cost of capital, and decreases investment

There are a number of negative implications of the stock market volatility. One implication is that market volatility influences the economy by having an impact on spending patterns of the consumer (Campbell, 1996; Starr-McCluer, 1998;Ludvigson and Steindel 1999 and Poterba 2000). The impact of volatility on consumer expenditure is related to the wealth effect. Increased wealth causes increased spending while fall in stock market reduces spending. Business investment (Zuliu, 1995) and economic growth (Levine and Zervos, 1996 andArestis et al 2001) are also directly concerned by stock market volatility. In case of increased volatility, equity investments can be seen as more risky and the investments can be shifted to relatively less risky assets.

3.2.1 Determinants of Stock market volatility

A increasing concern has come forward in recent years investigating the determinants of volatility spread across stock markets.

3.2.1.1 Inflation

The link between stock market returns and inflation, if any has raised the interest of researchers and practitioners in the same way mainly since the twentieth century. The basis of the discussion is the Fisher (1930) equity stocks declaration. According to the generalized Fisher (1930) hypothesis, equity stocks signify claims against real assets of a business; and as such, may provide a hedge against inflation. If so, then investors could exchange their financial assets in return for real assets when anticipated inflation is asserted. In such a situation, share prices in nominal terms should completely mirror expected inflation and the linkage between these two variables should be positively correlated ex ante (Ioannides, et.al., 2005:910). This debate of equity market providing a hedge against inflation may also mean that investors are wholly paid off for the increase in the general price level through equivalent rises in nominal share market returns and therefore, the real returns stay unaffected.

Further extension of the hedge hypothesis posits that since equities are claims as current and future earnings, then it is expected that in the long run as well, the stock market should equally serves as a hedge against inflation. Fama (1981) however, put up a proxy hypothesis when he argued the relationship between high rates of inflation and future real economic growth rates as negative. Views that rationalize the negative co-movements between inflation rates and real stocks returns however differ.

The inflation illusion hypothesis of Modigliani and Cohn (1970) point’s out, that the real effect of inflation is caused by money illusion. According to Bekaert and Engstrom (2007:1), inflation illusion suggest that when expected inflation rises, bond yields duly increase, but because equity investors incorrectly discount real cash flows using nominal rates, the increase in nominal yields leads to equity under-pricing and vice versa.

3.2.1.2 Interest Rate

Available literature in finance, discusses the relationship between interest rates and stock returns in different ways. Relating short term interest rates with stock returns and market volatility, Shanken (1990) and Campbell (1987) found that nominal one-month T-bill yield has a significantly positive relation with market variance but negatively correlated with future stock returns. Whitelaw (1994) also reported a positive relationship between market volatility and the one-month T-bill yield. Bren’ et al. (1989) provided evidence that one-month interest rate is helpful in predicting the sign and the varianceof the excess return on stocks.

Rizwan and Khan (2007) also examined role of macroeconomic variables and global factors on the volatility of the stock returns in Pakistan. They analyzed Pakistan’s equity market as a consequence of interest rate, exchange rate, industrial production, and money supply being domestic macroeconomic variables and 6-month LIBOR and Morgan Stanley Capital International (MSCI) All Countries World Index as global variables. After applying EGARCH and VAR models they collectively explained varying importance of domestic macroeconomic variables in explaining the relationship between stock returns and volatility in Karachi Stock Exchange and did not discussed contribution of each variable separately.

3.2.1.3 GDP growth

Empirical studies have identified that the economic fluctuations within a country influence stock market returns and volatility. Using the US data Schwert (1989b, 1990b) and others identified stock market volatility increases during economic recession. However, the influence from stock market volatility to macroeconomic volatility is higher than that from macroeconomic volatility to stock market volatility. According to Ritter (2005), the relationship between stock returns and economic growth is significant for investors to manage their portfolios utilizing the release of macroeconomics news to identify stock market trends.

In addition, Brooks et al. (1999) argued that the good and bad news of GDP and current account balance have no impact on stock returns. Groenewold (2003) also could not find an influence on the share prices from real output after deregulation of the financial market. However, the findings of Groenewold (2003) indicated that the share prices influence real output the during post- deregulation period. In contrast, Chaudhuri and Smiles (2004) identified a significant effect on the stock returns from the growth rate of real GDP. They also found that negative effect from the two lags of real consumptions towards the stock price movement.

Besides the influence from domestic economic factors, Kim and In (2002) and Kim (2003) identified international macroeconomic influence towards the stock returns and volatility. Even though these two studies incorporate influence from other countries to their models, their approaches are confined to univariate GARCH models. Thus, they did not capture the varying volatility implications on covolatility across local and international stock markets and macroeconomic variables from corresponding countries. The current study therefore, focuses to fill this gap in the literature.

3.2.1.4 Stocks traded

During the last decades a number of interesting studies have sought to explain the empirical relationship between trading volume and stock returns. The early literature is well represented by Ragalski (1978), Figlewski and Cornell (1981) who studied the basic relationship between the variables. The linear and non-linearcausality between the stock prices and trading voume has also received a substantial amount of attention in the literature Campbell et.al (1993), Hiemstra and Jones (1994). This investigation has also been extended to bond and futures markets Clark (1973), Hanna (1978), Grammatikos and Saunders (1986) and the examination of cross-country spillovers between trading volume and stock returns Lee and Rui (2002).

Furthermore, Ragunathan and Pecker (1997) focus on the relationship between volume and price variability for the Australian futures market and explore positive relationship between volume and volatility by documenting asymmetric volatility response to unexpected shocks in trading volume by using the model developed by Bessembinder and Seguin (1993). Positive unexpected shocks to trading volume were found to induce an average increase in volatility at 76 per cent, while negative unexpected shocks to trading volume induce a smaller response in volatility. Daigler and Wiley (1999) examine the volume-volatility relation in futures markets for Chicago Board of Trade for four types of traders.

Another stand of the literature has focused more directly on the casuality between trading volume and stock returns. Several studies have tested by using (VAR) Granger Causality between the two series using different samples and estimated techniques. Campbell, Grossman and Wang (1993) examine the level of price changes is influencedby high volume will tend to be reversed, and the reversal will be less due to price changes on days with low volume. Blume et.al (1994) derives that investors can able to predict the market information with past price and trading volume. Wang (1994) shows that investors trade informational and non-informational reasons will also lead to different dynamic between trading volume and stock returns.

3.2.1.5 Exchange Rate Regimes

There exists a branch of literature that considers the impact of exchange rate volatility on the macro economy, which depends on the exchange rate regime which the economy follows, although there has been no clear agreement on the ideal regime for macroeconomic performance.

Those who are in favour of fixed exchange rate regimes, such as Mc Kinnon (1963), Mundell (1973), Frankel and Rose 2002) stipulate that the macroeconomy growth is enhanced through higher trade levels which would promote economic stability, foreign direct investment, economic growth and hence standard of living. However, more recently, Fischer (2001), argues that fixed exchange rates would support speculative capital inflows, moral risk and overinvestment. On the other side, those who are in favour of flexible exchange rates (Meade 1951, Friedman 1953 et al), argue that fluctuating exchange rate helps to correct disequilibrium both, local and external, despite real asymmetric shock. Under a situation of fixed exchange rate regime and international capital mobility, money supply is believed to be derived such that money demand shocks cause money supply to change and therefore LM shocks leave output or inflation unchanged. Under a fixed exchange rate, an external shock is detrimental to the domestic economy. A decline in foreign income might lead to a fall in domestic demand for exports and since exports are an important function of aggregate demand, the adverse shock to aggregate demand will lead to a fall in domestic income and employment via the multiplier effect.

Under a system where exchange rate is determined by market forces, the effect will be alleviated through a depreciation of the exchange rate. Hence a foreign shock will have different effects under different exchange rate regimes. Similarly, a rise in foreign interest rates may lead to a depreciation and an increase in income under fluctuating exchange rates while under a fixed exchange rate system, there is bound to be a monetary contraction and a decrease in income. Empirical studies regarding exchange rate volatility and macroeconomic performance is limited in small island economies. However, empirical studies comprise of Baxter and Stockman (1989), Flood and Rose (1995),Crosby (2000), Bayoumi and Eichengreen (1994) and Kwan and Lui (1999). Baxter and Stockman (1989) reveal a smaller amount of evidence on macroeconomic behaviour or trade flows under differing exchange rate regimes for a sample of 49 countries.

3.2.2 Stock Volatility and Market Shocks

There are several economic reasons for which return shocks, to some extent can cause persistent changes in the level of market volatility, which can vary over time. These can be attributed to financial leverage effects or feedback volatility (risk premium) effects (French et al (1987), Schwert(1990), Campbell and Hentschel (1992), Bekaert and Wu (2000), or more recently, Mele (2007) and Ozdagli (2012)). If the above shifts in volatility are not taken into consideration, they will overemphasize evidence of very high persistence in volatility (Psaradakis and Tzavalis (1999)). As more recently noted by Malik (2011), a smaller degree of persistency can dampen the feedback volatility effects faster, and thus positive (good) return shocks will result in significant falls of volatility.

The empirical literature stated above treats large stock market return shocks as exogenous. To examine their effects on volatility, it relies on the intervention- dummy variable analysis of Box and Tiao (1975), based on exogenous information from the sample to determine the time points that the breaks driven by large shocks occur. Of course, more sophisticated multi break testing procedures can be applied to find out from the data the timing of the breaks, like those employed for breaks in the mean of series (Bai and Perron (2003)). But, as in the intervention analysis, these methods do not treat the break process as an endogenous process, specified as a part of volatility model. By doing this, volatility models can allocate for richer dynamics which can facilitate the classification of different economic sources (or market events) of volatility shifts from the data and to study the dynamic effects of market return shocks on volatility functions. Separating the impact of these return shocks on volatility from those of ordinary return shocks can also have important repercussions for long-term portfolio management and hedging, as it will bring more attention on controlling important sources of risks caused by long-term shifts in volatility leaving aside its short-term ones. As shown by many studies based on intervention analysis, these type of shifts in volatility or stock prices co-movements tend to be mainly driven by large market shocks (Karolyi and Stulz (1996); Chen et al (2003)).

Moreover, economic shocks lead to lower prices because of restricted opportunities for portfolio diversification since all stocks are connected to the domestic economy. Investors are compensated for assuming this risk by means of higher expected returns, which is explained by a higher cost of capital. In the integrated market, investors hold an internationally diversified portfolio meaning that bad news shocks in one country can be offset by good news shocks from elsewhere. Investors do not require a premium to compensate for individual market volatility meaning that the cost of capital is lower in integrated markets (Bekaert and Harvey, 1998)..

3.2.4 Implications of Stock Market Volatility

According to Krainer (2002), the extent of volatility in the stock market cam help to forecast the path of an economy’s growth and the composition of volatility can entail that investors now require to hold more securities in their portfolios to attain diversification

There are, however a number of negative implications of the stock market volatility. One implication is that market volatility influences the economy by having an impact on spending patterns of the consumer (Campbell, 1996; Starr-McCluer, 1998;Ludvigson and Steindel 1999 and Poterba 2000). The impact of volatility on consumer expenditure is linked to the wealth effect. Increased wealth causes increased spending while fall in stock market reduces spending.

However, a drop in stock market will weaken consumer assurance and thus reduce consumer spending. Stock market volatility may also have an effect on business investment (Zuliu, 1995) and economic growth directly (Levine and Zervos, 1996 and Arestis et al 2001). An increase in stock market volatility can be taken as an increase in risk of investing in stocks and therefore a transfer of funds to less risky assets. This shift could lead to a rise in cost of finance to businesses and consequently new business might tolerate this effect as investors will turn to acquire shares in larger, renowned firms.

3.2.5 Previous Studies on Stock Market Volatility

Stock prices volatility is an extremely important concept in finance for numerous reasons. Researchers in quest of the causes of volatility has investigated the stock prices volatility from different angels. In this regards, from late twentieth century and particularly after introducing ARCH model by Engle (1982), as said by Bollerslev (1999) and Granger and Poon (2000) several hundred research that mainly accomplished in developed country and to some extent in developing countries has been done by researchers in this area using different methodology. A glimpse of these studies is as follows:

Engle (1982) published a paper that measured the time-varying volatility. His model, ARCH, is based on the idea that a natural way to update a variance forecast is to average it with the most recent squired "surprise"(i.e. the squired deviation of the rate of return from its mean).While conventional time series and econometric models operate under an assumption of constant variance, the ARCH process allows the conditional variance to change over time as a function of past errors leaving the unconditional variance constant. In the empirical application of the ARCH model a relatively long lag in the conditional variance equation is often called for, and to avoid problems with negative variance parameters a fixed lag structure is typically imposed.

Bollerslev (1986) to overcome the ARCH limitations introduced his model, GARCH, that generalized the ARCH model to allow for both a longer memory and a more flexible lag structure. As noted above, in the empirical application of the ARCH model, a relatively long lag in the conditional variance equation is often called for, and to avoid problems with negative variance parameters a fixed lag structure is typically imposed. In the ARCH process the conditional variance is specified as a linear function of past sample variance only, whereas the GARCH process allows lagged conditional variances to enter in the model as well.

Engle and Ng (1993) measure the impact of bad and good news on volatility and report an asymmetry in stock market volatility towards good news as compared to bad news. More specifically, market volatility is assumed to be associated with the arrival of news. A sudden drop in price is associated with bad news on the other hand, a sudden increase in price is said to be due to good news. Engle and Ng find that bad news create more volatility than good news of equal importance. This asymmetric characteristic of market volatility has come to be known as the "leverage effect". The studies of Black (1976), Christie (1982), FSS (1987), Schwert (1990) and Pagan and Schwert (1989) also explain this volatility asymmetry with the" leverage effect". However, their models do not capture this asymmetry. Engle and Ng (1993) provide new diagnostic tests and models, which incorporate the asymmetry between the type of news and volatility, they advise researchers to use such enhanced models when studying volatility.